29 - 1  Pension plan terminology  Defined benefit versus defined contribution plans  Pension fund investment tactics  Retiree health benefits CHAPTER 29 Pension Plan Management 29 - 2  They constitute the largest class of investors.  They hold about 33% of all U. S. stocks. How important are pension funds? 29 - 3  Defined benefit plan: Employer agrees to give retirees a specific benefit, generally a percentage of final salary.  Defined contribution plan: Employer agrees to make specific payments into a retirement fund, frequently a mutual fund. Retirees’ benefits depend on the investment performance of their own fund. 401(k) is the most common type. Pension Plan Terminology (More ) 29 - 4  Profit sharing plan: Employer payments vary with the firm’s profits. (Defined contribution, but as a percentage of profits).  Cash balance plan: Employer promises to put a specified percentage of the employee’s salary into the plan, and to pay a specified return on the plan’s assets. (More ) 29 - 5  Vesting: Gives the employee the right to receive pension benefits at retirement even if he/she leaves the company before retirement.  Deferred vesting: Pension rights are not vested for the first few years.  Portability: A “portable” pension plan can be moved to another employer if the employee changes jobs. (More ) 29 - 6  Fully funded: Value of plan assets equals the present value of expected retirement benefits.  Underfunded: Plan assets are less than the PV of the benefits. An “unfunded liability” is said to exist.  Overfunded: The reverse of underfunded. (More ) 29 - 7  Actuarial rate of return: The rate of return:  used to find the PV of expected benefits (discount rate).  at which the fund’s assets are assumed to be invested.  Employee Retirement Income Security Act (ERISA): The federal law governing the administration and structure of corporate pension plans. (More ) 29 - 8  Pension Benefit Guarantee Corporation (PBGC):  A government agency created by ERISA to ensure that employees of firms which go bankrupt before their defined benefit plans are fully funded will receive some minimum level of benefits.  However, for high income employees (i.e., airline pilots), PBGC pension payments are often less than those promised by the company. 29 - 9  Financial Accounting Standards Board (FASB), together with the SEC, establishes rules for reporting pension information.  Pension costs are huge, and assumptions have major effect on reported profits. Who establishes guidelines for reporting pension fund information on corporate financial statements? 29 - 10  Defined Contribution Plan:  The annual contribution is shown as a cost on the income statement.  A note explains the entry.  Defined Benefit Plan:  The plan’s funding status must be reported directly on the balance sheet. How are pension fund data reported in a firm’s financial statements? (More ) [...]... Don’t know what the annual pension payment will be (the $20,000)  Don’t know what rate of return the pension fund will earn (the 10%)  A large number of employees creates complexities, but it also reduces the aggregate actuarial uncertainty 29 - 17 What risks are borne by the plan sponsor and plan beneficiaries under the four types of pension plans?  Defined benefit plan: Most risk falls on the... specified return 29 - 20 What type of companies tend to have each type of plan?  Large, more mature companies (and governments) tend to use defined benefit plans  New, start-up companies tend to use profit sharing plans  Many older companies are shifting to defined contribution and cash balance plans 29 - 21 If a company uses either a defined contribution or a profit sharing plan, how are the... the needed funds, hence must make larger annual contributions 29 - 23 Does the type of pension plan influence the possibility of sex discrimination? Since women live longer than men, female employees are more costly under defined benefit plans 29 - 24 How does the type of pension plan influence employee training costs?  Defined benefit plans encourage employees to stay with a single company, hence... actuarial calculations? 29 - 27 What is the primary goal of a plan s investment strategy?  To structure the portfolio to minimize the risk of not achieving the assumed actuarial rate of return  A low risk portfolio will mean low expected returns, which will mean larger annual contributions, which hurt profits 29 - 28 How can a company judge the performance of its pension plan managers?  Alpha analysis:... risk profile) 29 - 29 What’s meant by “tapping” pension fund assets?  This occurs when a company terminates an overfunded defined benefit plan, uses a portion of the funds to purchase annuities which provide the promised pensions to employees, and then recovers the excess for use by the firm  First used by corporate raiders after takeovers, with proceeds used to pay down takeover debt 29 - 30 Why... 20000 PV 0 0 PMT FV Compute PV = $152,121.59 Output 152,122 29 - 14 Determine the annual contribution during the employment years With $152,122 to be accumulated, the answer is $343.71 Step 2: Input 10 0 N Output 40 I PV 152122 PMT 343.71 FV 29 - 15 Graph of Pension Fund Assets Dollars ($000) 152 0 40 55 Years 29 - 16 Pension fund management is much more complex than this illustration  Don’t know how... costs 29 - 25 Does the type of pension plan influence the militancy of unions when a company faces financial adversity? Benefits paid under defined benefit plans are usually tied to the number of years worked and the final (or last few) year’s salary Therefore, unions are more likely to work with a firm to ensure its survival under a defined benefit plan 29 - 26 What are the two components of a plan s... profitability or the return on the plan s assets (More ) 29 - 18  Defined contribution plan: Places more risk on employees, because benefits depend on the return performance of each employee’s chosen investment fund  Profit sharing: Most risk to employee, least to employer Company doesn’t pay into fund unless it has earnings, and employees bear investment risk (More ) 29 - 19  Cash balance: “Middle... the assets administered?  Usually set up as a 401(k) plan  Employees make tax-deductible contributions into one or more investment vehicles (often mutual funds) established by the company  Company may make independent or matching contributions 29 - 22 Does the type of pension plan influence the possibility of age discrimination? Defined benefit plans are more costly to firms when older workers are... the employee’s working life to fully fund the plan by retirement age?  Data/Assumptions: Employee begins work at 25, will work 40 years until 65, and then retire Employee will live another 15 years, to age 80, and will draw a pension of $20,000 per year The plan s actuarial rate of return is 10% 29 - 13 Determine the amount the firm must have in the plan at the time the employee retires It is $152,122 . 29 - 1  Pension plan terminology  Defined benefit versus defined contribution plans  Pension fund investment tactics  Retiree health benefits CHAPTER 29 Pension Plan Management 29 -. plan s assets. What risks are borne by the plan sponsor and plan beneficiaries under the four types of pension plans? (More ) 29 - 18  Defined contribution plan: Places more risk on employees,. retirement.  Deferred vesting: Pension rights are not vested for the first few years.  Portability: A “portable” pension plan can be moved to another employer if the employee changes jobs. (More ) 29 - 6  Fully